The Basics of Lease Accounting
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1 The Basics of Lease Accounting Joe Sebik, VP - Global Originations & Structuring J. P. Morgan Leasing, Inc. (212) joseph.p.sebik@jpmorgan.com Howard Thompson, Director - Pricing & Economics Key Equipment Finance (518) howard.k.thompson@key.com 1
2 Course Outline Definition of a lease The lease versus buy decision Types of leases Lease classification Lease examples Accounting treatment of leases Q&A 2
3 What Is a Lease? An agreement that conveys the right to use property, generally for a specified period of time Parties to a lease are Lessor owner of the asset who receives payments Lessee user of the asset who makes payments 3
4 Lease Versus Buy For lessees To reduce the cost of capital To manage taxes To obtain 100% financing To manage assets Potential off-balance sheet treatment To gain convenience and efficiency For lessors Retain tax advantages of asset ownership to shelter income Retain residual value Provide creative financing alternatives 4
5 Types of Leases Lessee s point of view Operating lease Capital lease Lessor s point of view Operating lease Direct finance lease Sales-type lease Leveraged lease 5
6 Lease Classification Criteria A lease is a finance or capital lease if it meets any one of the following criteria 1. Lease transfers title 2. Lease contains a bargain purchase option 3. Lease term is 75% of the estimated useful life of the leased asset 4. Present value of the minimum lease payments is 90% of the fair value of the leased asset In addition to the lease criteria, a lease must meet both of the following in order for a lessor to classify it as a finance lease Collectibility is reasonably assured No important uncertainties exist concerning any future obligations of the lessor 6
7 Criteria #2 Bargain Purchase Option An option price that is considered to be sufficiently below expected fair value (the sale price in an arms-length transaction) so as to make the exercise of the option appear to be reasonably assured at inception 7
8 Criteria #3 75% Test Lease term fixed, non-cancelable term during which the lessee can be compelled to make payments plus All periods for which failure to renew the lease imposes a penalty on the lessee in such amounts that a renewal appears to be reasonably assured OR Periods covered by ordinary renewal options preceding a bargain purchase option Any periods covered by a bargain renewal option Estimated useful life estimated remaining period during which the asset is expected to be economically useful 8
9 Criteria #4 90% Test Minimum lease payments (MLPs) include The payments required or expected to be made by the lessee during the lease term Amounts guaranteed by the lessee, plus (lessors only) amounts guaranteed at inception by third parties Penalties the lessee must pay for failure to renew or extend A penalty is any requirement of the lessee to disburse cash, incur or assume a liability, perform services, surrender or transfer an asset, or right to an asset, or otherwise forego an economic benefit or suffer an economic detriment 9
10 Criteria #4 (cont.) 90% Test MLPs do not include contingent rentals These are rent payments that are not fixed but are dependent on other factors or circumstances The rate used in present valuing the MLPs by The lessor is the implicit rate The lessee is the incremental borrowing rate unless the implicit rate is known 10
11 Operating Leases Balance Sheet Lessor Leased asset is recorded at cost and is included in or near property, plant and equipment, net of accumulated depreciation Lessee No asset or liability recorded 11
12 Operating Leases Income Statement Lessor Lease income recognized on a straight-line basis over life of the lease (accrue rent income if rents are uneven) Depreciation recorded in accordance with company s depreciation policy Initial direct costs (IDCs) are deferred and amortized again income over the lease term Lease expense recognized on a straight-line basis over life of the lease (accrue rent expense if rents are uneven) N/A N/A Lessee IDCs are costs incurred by the lessor in negotiating the lease transaction (e.g., commissions, legal fees, etc.) 12
13 Operating Leases Disclosures Lessor Cost or carrying amount and accumulated depreciation Minimum future rentals in total for each of the next 5 years and total N/A Lessee Minimum future rentals in total for each of the next 5 years and total 13
14 Operating Lease Example Assumptions: Fair market value (FMV) Equipment cost Monthly rent: Months 1-12 Months Months Term in months Estimated residual value 100, ,000 2,500 3,000 3, ,000 Lessor classification: Operating lease because PV of MLPs <90% of FMV 14
15 Operating Lease Example Monthly lease income: 2,500 x 12 mo = 30, ,000 x 12 mo = 36, ,500 x 12 mo = 42,000 Total = 108, mo = 3,000 Monthly depreciation expense: Equipment cost = 100,000 Less: residual value = (20,000) Total depreciation = 80, mo = 2,222 15
16 Operating Lease Example Lessor Accounting entries: DR. (CR.) Record investment: Operating lease cost 100,000 Cash [to book asset] 100,000 Monthly: Accrued rent 3,000 Lease income 3,000 Depreciation expense 2,222 Accumulated depreciation 2,222 Cash* (months 1-12) 2,500 Accrued rent* (months 1-12) [collection of rent] 2,500 *Amounts should reflect actual cash flows 16
17 Operating Lease Example Financial Statements Income Statement Year 1 Year 2 Year 3 Lease income 36,000 36,000 36,000 Depreciation expense (26,667) (26,667) (26,666) Pre-tax income 9,333 9,333 9,334 Note: Example ignores income taxes and interest cost to fund asset. 17
18 Operating Lease Example Financial Statements (cont.) Balance Sheet Year 1 Year 2 Year 3 Cash 30,000 66, ,000 Investment in leases: Operating lease cost 100, , ,000 Accumulated deprecation (26,667) (53,334) (80,000) Net lease investment 73,330 46,666 20,000 Accrued rents 6,000 6, Total assets 109, , ,000 Common stock 100, , ,000 Retained earnings 9,333 18,666 28,000 Total liabilities and equity 109, , ,000 18
19 Direct Finance or Capital Leases Balance Sheet Lessor Direct Finance Lease Investment in the lease is recorded at FMV, FMV = carrying cost Investment consists of: 1. Sum of the MLPs, including any residual value guarantees and 2. The estimated residual value Lessee Capital Lease Investment in asset and obligation is recorded at an amount equal to the present value of the MLPs Asset is included in or near property, plant and equipment, net of accumulated depreciation 19
20 Direct Finance or Capital Leases Income Statement Lessor Direct Finance Lease Lease income recognized to produce a constant rate of return on the investment balance over the life of the lease Initial direct costs are deferred and amortized into income over the lease term Lessee Capital Lease Depreciation on the asset is recorded in accordance with the company s depreciation policy Lessee payments over the lease term are prorated between interest expense and the reduction of the obligations 20
21 Direct Finance Lease Example Assumptions: Fair market value Equipment cost Monthly rent Term in months Estimated residual value 100, ,000 3, ,000 Lessor classification: Direct finance lease because PV of MLPs 90% of FMV 21
22 22 Direct Finance Lease Example 80,003 53,197 TOTALS 2,189 1,511 67, (Residual value) 19, ,141 1,559 69, , , ,095 1,605 72, , , ,049 1,651 74, , , ,004 1,696 76, , , ,961 1,739 78, , , ,918 1,782 79, , , ,876 1,824 81, , , ,835 1,865 83, , , ,795 1,905 85, ,669 1,031 46, ,756 1,944 87, ,611 1,089 48, ,718 1,982 88, ,554 1,146 51, ,681 2,019 90, ,499 1,201 53, ,644 2,056 92, ,444 1,256 56, ,608 2,092 93, ,391 1,309 58, ,573 2,127 95, ,339 1,361 61, ,539 2,161 97, ,288 1,412 63, ,505 2,195 98, ,238 1,462 65, ,473 2, ,000 1 Principal Paydown Interest Earned Asset Value Mo Principal Paydown Interest Earned Asset Value Mo Implicit rate = 26.73% Monthly payment = 3,700
23 Direct Finance Lease Example Mo Asset Value Monthly payment = 3, ,000 98,528 97,022 95,483 93,910 92,302 90,658 88,978 87,260 85,503 83,708 81,872 Interest Earned 2,228 2,195 2,161 2,127 2,092 2,056 2,019 1,982 1,944 1,905 1,865 1,824 Principal Paydown 1,473 1,505 1,539 1,573 1,608 1,644 1,681 1,718 1,756 1,795 1,835 1,876 Total income for year 1 = 24,398 23
24 Direct Finance Lease Example Lessor Accounting entries: Record investment: Month #1: Month #2: Contracts receivable* Unguaranteed residual Cash Unearned income Unearned income Lease income ([to book income] Cash Contracts receivable [to book rent received] Unearned income Lease income Cash Contracts receivable DR. 133,200 20,000 2,228 3,700 2,195 3,700 (CR.) 100,000 53,200 2,228 3,700 2,195 3, *Total rents 36 months x 3,700 = 133,200
25 Direct Finance Lease Example Financial Statements Income Statement Year 1 Year 2 Year 3 Lease income 24,398 18,343 10,459 Pre-tax income 24,398 18,343 10,459 Note: Example ignores income taxes and interest cost to fund asset. 25
26 Direct Finance Lease Example Financial Statements (cont.) Balance Sheet Year 1 Year 2 Year 3 Cash 44,400 88, ,200 Investment in leases: Contracts receivable 88,800 44, Unguaranteed residual 20,000 20,000 20,000 Unearned income (28,802) (10,459) -- Net lease investment 79,998 53,941 20,000 Total assets 124, , ,200 Common stock 100, , ,000 Retained earnings 24,398 42,741 53,200 Total liabilities and equity 124, , ,200 26
27 Sales-Type Leases Accounting Same as direct finance lease except FMV is not equal to carrying cost Difference between FMV and carrying cost is recognized as a gain or loss at the inception of the lease 27
28 Sales-Type Lease Example Assumptions: Fair market value Equipment cost Monthly rent Term in months Estimated residual value 100,000 95,000 3, ,000 Lessor classification: Sales-type lease because PV of MLPs 90% of FMV and 5,000 dealer profit 28
29 Sales-Type Lease Example Lessor Accounting entries: Record investment: Month #1: Month #2: Contracts receivable Unguaranteed residual Sales-type gain Inventory Unearned income Unearned income Lease income Cash Contracts receivable Unearned income Lease income Cash Contracts receivable DR. 133,200 20,000 2,228 3,700 2,195 3,700 (CR.) 5,000 95,000 53,200 2,228 3,700 2,195 3,700 29
30 Sales-Type Lease Example Financial Statements Income Statement Year 1 Year 2 Year 3 Sales-type gain 5, Lease income 24,398 18,343 10,459 Pre-tax income 29,398 18,343 10,459 Note: Example ignores income taxes and interest cost to fund asset. 30
31 Sales-Type Lease Example Financial Statements (cont.) Balance Sheet Year 1 Year 2 Year 3 Cash 44,400 88, ,200 Investment in leases: Contracts receivable 88,800 44, Unguaranteed residual 20,000 20,000 20,000 Unearned income (28,802) (10,459) -- Net lease investment 79,998 53,941 20,000 Total assets 124, , ,200 Common stock 95,000 95,000 95,000 Retained earnings 23,398 47,741 58,200 Total liabilities and equity 124, , ,200 31
32 Return on Investment Comparison Year 1 Year 2 Year 3 Operating lease Pre-tax income 9,333 9,333 9,334 Average investment balance 86,667 60,000 33,333 Return on average investment 11% 16% 28% Direct finance lease Pre-tax income 24,398 18,343 10,459 Average investment balance 89,999 66,970 36,971 Return on average investment 27% 27% 27% This demonstrates why lessors strive to achieve direct finance lease classification The earnings pattern is more consistent through the term of the lease (not back ended) 32
33 Questions??? 33
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